We don’t have to bail out 38 Studios

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38 Studios is Rhode Island’s latest big disaster.   But we’re not the only place that has suffered from politicians making dubious deals with well-connected businesses.  Other places in America have freed themselves from collapsing insider deals, and we can, too.  Here are the facts.

In 2010, State House leaders wanted to find $75 million for 38 Studios.  They didn’t have that much money to spend then.  They couldn’t even have the state borrow the money.  The RI constitution says, wisely, that the state can’t have any significant peacetime debt unless voters approve it on the ballot.  Voters wouldn’t have approved a state bond for 38 Studios even in 2010.  Polls that year showed that over 50% opposed the 38 Studios deal.

So political leaders got the RI Economic Development Corporation to borrow the money from financial markets and give most of it to 38 Studios. Since 38 Studios has collapsed, the question is whether taxpayers should bail out the Wall Street lenders.  There’s good precedent for not doing a bailout.  But our leaders want Rhode Islanders to pay.

Wall Street lenders lent this money to the EDC, which isn’t set up as part of the state government — the money wasn’t borrowed by Rhode Island.  The EDC is a company outside the RI government, run by political appointees, and its debt is separate from the state’s. Nowhere is there any legal obligation for the state to pay the EDC’s debt. The RI constitution says clearly that loans like this, made without voter approval, are not “state debts”, and that politicians are not allowed “to pledge the faith of the state for the payment of the obligations of others”. The constitution, which is the highest state law, is right about what isn’t state debt. Politicians’ actions had no power to make this deal into a kind of state debt, because their actions can’t go beyond the constitution. They had no power to pledge Rhode Island’s faith for spending money on this, so their actions can’t give us any sort of obligation to do this bailout.

Besides, the 38 Studios loan was fully backed by an insurer, Assured Guaranty Municipal.  Wall Street lenders will get their money back, plus all interest, no matter what.  They don’t need a state bailout.

Advocates of a bailout say RI has a “moral obligation” to pay. That’s misleading. Here’s the real situation. Before this money was borrowed by the EDC, state politicians agreed to ensure that, if the deal didn’t work out, a bailout proposal would come up for debate as part of the budget. But the politicians couldn’t promise any bailout would happen. This situation, where the state stays out of the deal but politicians give a half-hint about a bailout, is what’s called a “moral obligation” in finance. In moral obligation deals, the government doesn’t commit to anything, politicians just give their half-hints.

This “moral obligation” maneuver was invented for New York State by John Mitchell, who was later convicted in the Watergate scandal.  In a 1984 interview, Mitchell admitted that moral obligation deals are “a form of political elitism that bypasses the voter’s right to a referendum”.  When politicians want a deal like 38 Studios that voters oppose, they arrange it off the books through a company like the EDC.  As Mitchell says, “moral obligation bonds were designed to get around the state constitution”. The constitution forbids political leaders from promising the state will back the debt, so they just say “We’ll consider it”.

Voters have rights, and when politicians sidestep our rights it doesn’t give us any moral obligation to spend money. Even if politicians had promised a bailout in the past, which they didn’t, the unethical actions of those politicians back then wouldn’t give Rhode Islanders a moral obligation to spend money now. If the politicians and their allies who borrowed the money against our will want to pay the lenders with their own personal funds, they can, but not at the expense of the people of Rhode Island. We continue to have the right to choose not to bail out Wall Street in the state’s coming budgets, because we the people weren’t consulted. And as the loan documents show, the lenders who signed up for the 38 Studios deal were told repeatedly that the state was “not obligated” to pay them back, and the insurer knew this too. This was an attempt to go around our constitutional rights, and big lenders and insurers don’t have any claim on us after they helped the politicians dodge the constitution’s requirements.

If we spend money on the bailout, it will be costly. The $75 million that the EDC borrowed comes, with interest, to $112 million. $23 million of the $75 million that was borrowed was set aside as reserve funds for the protection of the Wall Street lenders, and these reserve funds will automatically be used to pay some of the debt. We may also get a little money from a lawsuit and from selling the assets of 38 Studios and Curt Schilling. But the state would still be asked to pay a huge sum, $89 million or a little less over the course of the rest of this decade. We can’t afford to pay off Wall Street and squeeze Rhode Island. Rhode Island is already facing a $51 million revenue shortfall for its budget in the coming budget year.

Why are politicians even considering spending money on this now?

First, politicians like these off-the-budget deals.  Since John Mitchell pioneered them, they’ve spread to states and cities around the country.  In Rhode Island, these moral-obligation deals have failed spectacularly in the past — Fairmount Foundry, Alpha-Beta — and each time, RI politicians have stepped in and bailed out the Wall Street lenders, using money from voters who weren’t even consulted.  38 Studios is a considerably bigger failure, but won’t be the last if these deals continue.  After each failure, people have tried to stop these moral-obligation deals in RI.  But the deals have great advantages for politicians.  The politicians get to make cozy deals and promise more jobs, they avoid consulting voters, and the expense doesn’t hit the official budget until future years when the bailout happens.

A few places have actually refused to bail out these unofficial deals-gone-bad.  The courts support them.  The state of Washington and the Oklahoma cities of Tulsa and McAlester were all sued by lenders who claimed there was a “moral obligation” for government to spend money on a bailout.  In the McAlester case, a prominent judge ruled that the city had “no obligation”, period.  He added that it wasn’t even the city’s debt, and the city wasn’t liable.  Washington state won too.  Politicians in the city of Tulsa decided to settle out of court, and paid the bailout money, but some Tulsa residents went to court to dispute the settlement.  The state supreme court actually ruled that the city government had no business paying the bailout money, and ordered all the money to be given back to Tulsa.

Another reason for bailing out these deals is Wall Street’s pressure for bailouts.  Moody’s credit-rating agency has hinted that without a bailout, they may cut the credit ratings, not just for the EDC’s debt, but even for the voter-approved debt that RI is legally obligated to pay.

Fortunately, the record shows that we can avoid bailouts.  Tulsa’s credit rating wasn’t cut.  When Washington state refused to pay for the $2.2 billion default of the Washington Public Power Supply System, Wall Street was furious.   Most bond investors said they would demand much higher interest rates on Washington state’s official bonds in future, and one firm told its clients not to invest in Washington state bonds “regardless of the interest rate”.  But the damage was limited. Despite a study warning that Washington was going to pay up to 2% more on official bonds, the actual rate increase was only about .5% at first, and three months later it was only .2%.  One firm, Shearson, strongly recommended the bonds to clients, saying that they were now a great deal. A couple years later, discussions of Washington state’s official bonds considered the state’s overall financial picture and often didn’t even mention the WPPSS collapse.  Three years after the WPPSS default, Washington state refinanced the bonds that it issued at the height of the crisis and got a lower interest rate. The WPPSS catastrophe was 20 times bigger than 38 Studios, and lenders didn’t have insurance to protect them.   So repercussions for RI’s official state debt may be smaller still, though that’s not guaranteed.  But in any case, the precedent from Washington state suggests that Wall Street’s retaliation tends to be much smaller than the original threat.

Besides, we have a moral obligation not to spend money on this.  Rhode Island is now facing a budget crunch.  The latest figures show the state taking in about $50 million less than planned in revenue.  We owe real debts that politicians have refused to pay.  Our politicians have cut pensions, even though that involved violating a contractual obligation.  They let Central Falls go into bankruptcy, and other cities and towns have been dangerously close to bankruptcy, without the state being eager to help out.  But when it comes to Wall Street, even though we aren’t obligated to pay for 38 Studios, our leaders are eager to spend the public’s money making the rich richer.  They say we must not default on 38 Studios.  But it’s no default, because it wasn’t our debt, just a bad insider deal looking for a bailout. Our moral obligations say we shouldn’t pay.

What if we actually followed the constitution and put bonds on the ballot in the future? Shouldn’t we look into saving money that way?

When voters approve a bond on the ballot, lenders are always told that the state has an obligation to pay them but has no obligation to pay for so-called “moral obligation” deals.  That’s why lenders charge much less interest on debt that meets the constitution’s requirements, where the state itself borrows the money. The “moral obligation” bonds for 38 Studios charged the EDC high interest rates, ranging from 6% to 7.75%.  That’s roughly twice as much as the interest that the state pays on voter-approved bonds.  Moral obligation bonds are very expensive and inefficient ways to borrow money, and the need to set aside money for costs like insurance makes them even more expensive.

To replace moral-obligation bonds, we could also try a proven alternative, following North Dakota’s method of creating jobs.  They’ve long had the lowest unemployment in the country, while ours is terrible, and they have a state-owned Bank of North Dakota which can provide financing for economic development without having to go through Wall Street.  The Bank of North Dakota president suggests that other states could set up state-owned banks by issuing regular, voter-approved bonds. These bonds would have a low interest rate because they’re voter-approved.  If we did this in RI, we wouldn’t need things like moral-obligation bonds in future.  We would have low-interest money for the bank to lend out instead.  There would be room both for professional banking standards in lending, and also for the public to have a voice on the bank’s broad economic priorities.  The bank could be designed to allow input from the general public on overall priorities, but without allowing politicians to have enough influence to aim funding at specific companies.

Doing this would protect us a good deal. We would save a lot of money by cutting back on politicians’ tendency to arrange off-the-books loans with Wall Street, such as moral-obligation bonds and other loans that go around the constitution. These off-the-books loans are more expensive than voter-approved state bonds. Wall Street might try to hike the interest rate that it charges on off-the-books bonds, but that wouldn’t hurt us if we stopped using these off-the-books bonds. As we cut back on off-the-books loans, we can switch, either immediately or slowly, to voter-approved bonds, with the option of also adding cheap lending by the state bank. That would save us so much money that we’d be much better able to absorb any retaliation by Wall Street, even if Wall Street tries to hike the interest rate on voter-approved bonds too. Our voter-approved bonds have been attractive to investors for reasons that will continue to be true, so even if some on Wall Street try to hike our interest rate, other investors will be willing to lend to us and will keep the interest rate from rising very far.

So we could improve our financial picture if we financed things without using these expensive moral-obligation bonds from now on.  The only downside is that politicians wouldn’t be able to avoid putting deals like 38 Studios on the ballot. But although that’s bad for politicians making their cozy deals, letting voters have a say is good for Rhode Island.

Your voice matters! Sign our petition against the bailout.